Over the next twelve months, the challenge facing the financial sector
is transforming the existing interest based system into Riba free system.
The Supreme Court of Pakistan has given its verdict and also set the deadline, June 30,
2001, for completing the transformation according to Islamic Conjunctions (Shariah).
State Bank of Pakistan (SBP), banks and non-banking financial institutions (NBFIs) have
limited time at their disposal. The depositors and borrowers await anxiously to see the
complete blue-print of the new system and are also holding a substantial part of their
savings outside the banking system.

However, some financial sector experts say that the time frame allowed
by the Court was 'too short' keeping in view the quantum of work to be done and the pace
at which Pakistanis normally work  deferring the assignment till last minute.
Therefore, the Court may be requested by the GoP to extend the deadline. Others however,
say that the process of Islamization of banking system was initiated in mid eighties and
it should have been completed by this time.

While the issue of Islamic banking has yet to fully unfold other
developments are rapidly changing the banking landscape in Pakistan. The biggest paradigm
shift in the financial sector has been the sharp reduction in the interest rate structure
in the country whereby government bonds and National Savings Schemes rates have fallen by
more than 6 per cent over a short period of fifteen months since April 1998. At present
the one-year T-Bill rate is only 7 percent as compared to 14 per cent two years ago while
they had touched a peak of 17 per cent at one time. Secondly the freezing of foreign
currency accounts (FCAs) and end of swap deposits with SBP has changed the entire business
model for a large number of players in the banking industry  including foreign
banks. During the decade of nineties, easy money could be made by foreign banks by
bringing dollars into Pakistan, exchanging them for rupees and investing in high yielding
government bonds. No marketing, product development or other entrepreneurial efforts were
required. But time has changed.

Foreign and private sector banks have to work hard to earn their
living. With interest rates low, thin spreads have further narrowed, and lack of demand
for loans from industry means that asset formation is not an easy option. No wonder, we
are beginning to see some of the foreign banks packing up from Pakistan.

The first bank which decided to close its business in Pakistan is Bank
of America. The entire assets and liabilities of the Bank are being acquired by Union
Bank. By virtue of this takeover, deposits and advances of Union Bank will be doubled.
While merger of ANZ Grindlays Bank in Standard Chartered Bank was the result of a global
phenomena, which also happened in Pakistan, another foreign bank is expected to sell its
consumer banking division in Pakistan to some local bank. However, the fate depends on the
offer by the local bank. No doubt it is a prestigious franchise and can have a lot of
attraction for those who have still not considered it.

With foreign banks on the retreat, one has to find out how are domestic
players coping? There are two categories of domestic commercial banks operating in the
country. The first is the large-five, nationalized/privatized institutions, National Bank
of Pakistan, Habib Bank Limited (HBL), United Bank Limited (UBL), Muslim Commercial Bank
Limited (MCB) and Allied Bank of Pakistan Limited (ABL). Together, they account for almost
80 per cent of the total banks' assets and deposit base. MCB and ABL are already in
private hands but only MCB can claim to have successfully restructured and positioned
itself for future growth. The GoP is planning to partially privatize the remaining three
large banks by listing their shares on local stock exchanges.

The second category is the listed private banks. It is this group which
is under focus by not only investors but the central bank itself. In his address, at
Institute of Bankers in March this year, Dr. Ishrat Hussain, Governor, State Bank of
Pakistan, had expressed the need for reducing the number of commercial banks operating in
the country. He had suggested mergers and acquisitions mainly to improve the
competitiveness of the banks as well as strengthening their financial base. To expedite
the process of mergers and acquisitions, a possible step is to increase the capital base
from existing requirement of Rs 500 million to one billion rupees.

Banking sector experts say that this announcement may come any time. As
such this announcement will not be of any consequence to a large number of listed
commercial banks. If one looks at the annual accounts for the year 1999, shareholders'
equity of large number of banks exceeds one billion rupees. However, meeting such a
mandatory requirement will be a difficult task for those banks who faced extreme
difficulty in raising their capital base to Rs 500 million by December 31, 1999. Many
analysts term such banks inefficient and management lacking vision and suggest their
immediate takeover by other large size and fast growing banks. Closure of branches by
nationalized commercial banks (NCBs) offer private banks opportunities to expand and
rationalize their branch network. A question arises, why should a strong bank takeover an
inefficient bank? Acquisition of Trust Bank by Metropolitan Bank provides some clue to
this question.

Foreign commercial banks, after freezing of foreign currency accounts
(FCAs) are also redefining their policies. They seem to find it difficult, to operate with
low profit margin, due to limited number of branches. Multinational and blue chip
companies used to be their exclusive domain. However, with an invasion of domestic banks
in their enclave, they seem to be fast loosing the ground.

Both, domestic and foreign investors, await for privatization of HBL,
UBL and National Bank of Pakistan along with the sale of remaining shares of the GoP in
MCB and ABL. An interesting dimension has been added to this by the announcement of Rs 12
billion Rights Issue by HBL. These shares will be ultimately sold to the general public.
These shares will be offered to public at a par value of Rs 10 per share.

The difficulties facing First Women Bank Limited (FWBL) is smudge on
the face of a government which has promised to focus on strengthening state-owned
institutions. While substantial amounts were pumped into HBL and UBL, FWBL has been left
high and dry despite it being a model micro credit financial institution. There is need to
recapitalize, redefine its strategy and finalize whether it would be privatized or become
part of the GoP's poverty alleviation plan.

KEY PLAYERS

Askari Commercial Bank's deposits increased from Rs 23.4 billion
in 1998 to Rs 24.4 billion at the end of the year 1999. Whereas total assets rose by Rs
2.3 billion  from Rs 28.7 billion to Rs 31 billion, registering a growth of over 8
per cent. As the rates on T-Bills came down drastically low, the Bank changed its
strategy. The aggressive but prudent lending policy led to an increase of over 35 per cent
in advances portfolio. At the same time total investment in government papers reduced from
Rs 13.4 billion to Rs 8 billion. The bank declared 17.5 per cent dividend for the year
1999 as compared to a payout of 20 per cent for the previous year.

Bank AL Habib posted lower pre tax profit in 1999 as compared to
previous year  decline from Rs 444 million to about Rs 373 million. However,
deposits increased to Rs 14 billion as compared to Rs 13 billion during this period.
Within the overall framework of the Bank's lending policy, advances jumped from Rs 7.6
billion to Rs 10.9 billion. During the year two more branches were opened bringing the
total number of branches to 30. While the paid up capital would be increased to more than
Rs 600 million as a result of 20 per cent bonus shares, shareholders' equity was Rs 1.169
billion as on December 31, 1999.

Bank of Punjab's performance during 1999 remained satisfactory
if viewed in the context of prevailing economic conditions. The Bank's pre-provision and
pre tax adjusted profit was about Rs 206 million as against a profit of Rs 39 million for
the year 1998. For the year the Bank posted a pre tax profit of Rs 124.7 billion and was
able to maintain steady growth by generating income from advances, fee based business and
other activities. Special emphasis was given to restructuring of deposits mix to ensure a
positive spread  though there was a decline from Rs 17 billion to Rs 15 billion as
compared to the previous year. During 1999 the Bank made Rs 81 million provision against
non-performing advances, whereas it had written back Rs 125 million in the previous year.
While paid-up capital of the Bank as on December 31, 1999 was about Rs 852 million,
shareholders' equity was Rs 1.8 billion.

Faysal Bank has incurred loss before tax of Rs 117 million for
the year 1999 as compared to a pre tax profit of Rs 419 million for the previous year. It
also witnessed reduction in total assets as well as deposits. Deposits came down from Rs
18.7 billion to Rs 14.4 billion at the end of December 1999. The Bank has a paid-up
capital of Rs 1.2 billion and the Directors recommended to increase the authorized capital
to Rs 2 billion to facilitate the increase in paid-up capital by issuing 25 per cent Right
Shares. At present 60 per cent shares are held by Faysal Islamic Bank of Bahrain and
remaining 40 per cent are held by NIT, general public and employees. The Bank has 11
branches throughout Pakistan out of which three are located in Karachi.

First Women Bank registered over 16 per cent increase in
deposits during the year 1999 as compared to the previous year. This was despite its
disadvantageous position and its delistment from public sector banks  eligible for
maintaining public sector corporation deposits. The deposit mix also improved a bit as
such weighted average cost of deposits came down to Rs 4.6 per cent in the year as against
5.7 per cent during the year 1998. Due to a drastic fall in yield on T-Bills, bank
diverted funds to call and reverse repo lending in order to earn better return. The
investment of the Bank went down from Rs 1.2 billion to Rs 667 million during this period.
Decline in T-Bill yield and reduction in lending rates had a negative impact on the
profitability of the Bank. Operational profit came down to Rs 21.7 million in 1999 as
compared to over Rs 34 million for the previous year.

Habib Bank has made a welcome return to its policy of providing
aggressively for its non-performing loans. The bank has posted an after tax loss of around
Rs 9 billion as a result of provisioning of about Rs 5 billion. The policy is aimed
towards attaining a stronger financial health and part of plan for listing the Bank at
local stock exchanges. The listing of the Bank promises to be a milestone. The 100 per
cent Right Issues, and its subsequent sale to general public is the part of privatization
of the Bank. In a weak interest rate environment, the Bank is expected to experience in
NPLs and also to benefit from last year's recovery campaign.

Soneri Bank posted a pre tax profit of Rs 382 million in 1999 as
against a profit of Rs 335 million for the previous year. The break-up value per share,
having a face value of Rs 10, improved from Rs 19.36 to Rs 22.01 during this period. It
also announced 25 per cent bonus issue. For the year 1998 it had paid 10 per cent cash
dividend and 10 per cent bonus shares. It registered growth in deposits, investments,
financing to customers and also growth in volume of international trade business.

Metropolitan Bank has witnessed about 9 per cent increase in
profit before tax  from Rs 573 million in the previous year to Rs 521 million in
1999. Deposits increased from 10.7 billion to Rs 12 billion  a growth of nearly 13
per cent. An interesting feature was over 23 per cent increase in advances whereas there
was 16 per cent decline in investment. While the paid-up capital has been increased with
25 per cent bonus shares, shareholders equity stands at Rs 1.227 billion. During the year
the Bank installed SWIFT satellite-based system used for cross border transaction. With
effect from February 21, this year the Pakistan operations of Trust Bank of Kenya were
amalgamated with the Bank.

Muslim Commercial Bank managed to achieve a significant growth
of over 42 per cent in its pre tax profit for the year 1999 over the previous year despite
depressed level of economic activity in the country. The profit after tax came to about Rs
569 million  slightly more than our forecast. Even after distribution of 15 per cent
dividend for the year 1999, the Bank's capital adequacy ratio was 8.46 per cent. Despite
shedding expensive accounts, the Bank recorded over 6 per cent increase in deposits 
from Rs 128.8 billion to Rs 130.34 billion. Due to more stringent credit extension policy
advances came down during the year 1999 and the Bank maintained 60 per cent
loan-to-deposit ratio. The 10 per cent bonus share are to be issued on paid-up capital of
Rs 1.82 billion. A financially stronger position of the Bank would pave the way for off
loading of 24 per cent shares at premium.

National Bank of Pakistan has not released its annual report as
yet. The Bank is expected to post over Rs 3 billion profit before tax for the year 1999.
The Bank had posted Rs 1.2 billion loss last year. Banking sector experts say that the
efforts made by the president and his team seems to have made a positive impact on the
performance of the Bank. It is expected that deposits will be higher and non-performing
loans as a percentage of total advances will be lower as compared to the figures for the
year 1998. While the Bank contributed Rs 1.9 billion to national exchequer in the previous
year, the amount would be over Rs 2 billion for the year 1999.

Union Bank went through the change in management in August 1999.
A Middle Eastern Group bought the controlling stake in the Bank from Saigol Group.
According to the new policy, while the bank will remain primarily a working capital
lender, the focus will shift towards providing a wide array of financial services and
products to large and medium size blue chip companies.

United Bank made substantial progress in its overall
restructuring programme during the year 1999. The highlights are: an operating profit of
Rs 1.4 billion, an increase in NRFF and growth in fee-based income and about 9 per cent
growth in deposits. This growth was mostly driven from corporate customers where advances
increased by 92 per cent to Rs 25 billion. There was a significant reduction in
non-performing loans (NPL). Net of provisions, the Bank's NPLs as a percentage of net
advances decreased to 29 per cent from 35 per cent in the previous year. As regards
international operations, all overseas units reported profit during the year. The
highlights were: an across the board shedding of expensive deposits, a significant
rationalization and upgrading of human resource base, substantial recoveries, and a shift
away from lending and focus on network business and trade finance.

OUTLOOK

Going forward the writing is clearly on the wall. Unless local banking
industry changes its habits and broaden its vision it will continue to suffer from low
profitability and marginal returns on assets. The way forward is to focus on new venues
such as consumer banking, technology financing, internet banking and domestic corporate
finance activity. While certainly, initial risk will be higher, profit potential is also
high in these areas and not only that but there is a need for such services to consumers
as is being enjoyed in rest of Asia. Further, there is a huge potential for housing
finance in Pakistan which has a shortage of 1.5 million housing units. The central bank
should work with law ministry to bring suitable changes in foreclosure laws so that banks
can play their due role in developing this important industry which will boost economic
activity in the country.